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Essentials Of Investments
Found in: Page 284
Essentials Of Investments

Essentials Of Investments

Book edition 9th
Author(s) Zvi Bodie, Alex Kane, Alan Marcus, Alan J. Marcus
Pages 748 pages
ISBN 9780078034695

Short Answer

Question: Don Sampson begins a meeting with his financial adviser by outlining his investment philosophy as shown below:

Statement Number

Statement

1

Investments should offer strong return potential but with very limited risk. I prefer to be conservative and to minimize losses, even if I miss out on substantial growth opportunities.

2

All nongovernmental investments should be in industry-leading and financially strong companies.

3

Income needs should be met entirely through interest income and cash dividends. All equity securities held should pay cash dividends.

4

Investment decisions should be based primarily on consensus forecasts of general economic conditions and company-specific growth.

5

If an investment falls below the purchase price, that security should be retained until it returns to its original cost. Conversely, I prefer to take quick profits on successful investments.

6

I will direct the purchase of investments, including derivative securities, periodically. These aggressive investments result from personal research and may not prove consistent with my investment policy.

I have not kept records on the performance of similar past investments, but I have had some “big winners.”

Select the statement from the table above that best illustrates each of the following behavioral finance concepts. Justify your selection.

i. Mental accounting.

ii. Overconfidence (illusion of control).

iii. Reference dependence (framing).

Answer

i. Mental accounting. – Statement 3

ii. Overconfidence (illusion of control) – Statement 6

iii. Reference dependence (framing) - Statement 5

See the step by step solution

Step by Step Solution

Step 1: Definition

Mental accounting is a process through which investors segregate their funds into dividends and capital gains, maintain a set of separate mental accounts and do not combine outcomes i.e. keep loss in one account separate from another account.

 Step 2: Explanation on the behavioral characteristics

Statement no.

Behavioral finance concepts & Explanation

3

Mental accounting: Through this investors segregate their funds into separate mental accounts, do not combine outcomes. In this, the investor also prefers for dividends over capital gains.

6

Over confidence: Simpson’s desire to select investment that is inconsistent with his overall strategy shows overconfidence. Such traits often exhibit risk seeking behavior.

5

Reference dependence: Simpson’s desire to retain poor performing investment and take quick profit suggests reference dependence.

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